1. Field of the Invention
The present invention relates generally to financial trading systems and more particularly to the processing, valuating, and trading of weather-based financial instruments such as derivatives and the like.
2. Related Art
In today""s financial markets, the use of financial instruments known as xe2x80x9cderivativesxe2x80x9d have exponentially grown and is now common place. A derivative is an investment vehicle whose value is based on the value of another security or underlying asset. That is, a derivative is essentially a financial instrument that is derived from the future movement of something that cannot be predicted with certainty. By the late 1990""s the Office of the Comptroller of the Currency estimates that commercial banks in the United States alone, held over twenty trillion dollars worth of derivative-based assets. Common examples of derivatives include futures contracts, forward contracts, options, and swaps, all of which are briefly explained below.
Forward and futures contracts are standardized, transferable agreements, which may be exchange-traded, to buy or sell a commodity (e.g., a particular crop, livestock, oil, gas, etc.). These contracts typically involve an agreed-upon place and time in the future between two parties.
Options contracts are agreements, that may be exchange-traded, among two parties that represent the right to buy or sell a specified amount of an underlying security (e.g., a stock, bond, futures contract, etc.) at a specified price within a specified time. The parties of options contracts are purchasers who acquire xe2x80x9crights,xe2x80x9d and sellers who assume xe2x80x9cobligations.xe2x80x9d Further, a xe2x80x9ccallxe2x80x9d option contract is one giving the owner the right to buy, whereas a xe2x80x9cputxe2x80x9d option contract is one giving the owner the right to sell the underlying security. There is typically an up-front, non-refundable premium that the buyer pays the seller to obtain the option rights.
Swaps allow entities to exchange variable cash flows for fixed payments. They are similar to options but no premium (i.e., up-front money) is paid to obtain the rights. It is essentially an outright trade based on the expected movement of the price of the derivative""s underlying commodity.
Derivatives are typically used by institutional investors to increase overall portfolio return or to hedge or revoke portfolio risks. Derivatives are also frequently used by banks, companies, organizations, and the like to protect against market risks in general. For example, utility companies may be interested in protecting against meeting heating or cooling demands when unexpected weather occurs, and banks may be interested in protecting against the risk of loan defaults. Derivatives help in managing risks by allowing such banks, companies, organizations, and the like to divide their risk into several pieces that may be passed off to other entities who are willing to shoulder the risk for an up-front fee or future payment stream.
Derivatives, being financial instruments, may be traded among investors as are stocks, bonds, and the like. Thus, in order to trade derivatives, there must be a mechanism to price them so that traders may exchange them in an open market.
The relationship between the value of a derivative and the underlying asset are not linear and can be very complex. Economists have developed pricing models in order to valuate certain types of derivatives. As is well known in the relevant art(s), the Black-Scholes option pricing model is the most influential and extensively used pricing model. The Black-Scholes model is based on stochastic calculus and is described in detail in a variety of publicly available documents, such as Chriss, Neil A., The Black-Scholes and Beyond Interactive Toolkit: A Step-by-Step Guide to In-depth Option Pricing Models, McGraw-Hill, 1997, ISBN: 078631026X (USA), which is incorporated herein by reference in its entirety.
Whether using the Black-Scholes or any other pricing model, each has inherent flaws and thus poses risks. It has been estimated that some 40% of losses in dealing with derivatives can be traced to problems related to pricing models.
Risks in relying on any model includes errors in the model""s underlying assumptions, errors in calculation when using the model, and failure to account for variables (i.e., occurrences) that may affect the underlying assets. When considering the latter riskxe2x80x94failure to account for occurrences that may affect pricexe2x80x94weather is one occurrence which has been historically been overlooked. That is, weather, and more specifically future weather, has not been included as a formal variable in pricing models.
The few models that have considered weather usually have only considered past (i.e., historical) weather data. That is, most models assume, for example, that the previous year""s weather and its effects on businesses, etc. will repeat from year to year. Historical analysis has shown, however, that this assumption is true only 25% of the time. Thus, regardless of the commodity, risk management trading techniques or vehicles, traders essentially have been operating in the xe2x80x9cblindxe2x80x9d without knowledge of future weather conditions.
The present invention is a system, method, and computer program product for valuating (and thus, processing and trading) weather-based financial instruments and/or financial instruments that are impacted in some manner by weather. The method preferably involves specifying a start date and maturity date for the financial instrument, and selecting at least one geographic region to be covered by the financial instrument. Then, at least one weather condition (e.g., precipitation, HDDs, CDDs, etc.) that the financial instruments will derive its value from or is related to (or impacted by) is selected. A financial database may then be accessed so that a risk-free rate can be specified. A weather history database is then accessed to obtain historic weather information for the geographic location during the period between the start date and the maturity date. A weather forecast database is also accessed to obtain future weather information for the geographic location during the period between the start date and the maturity date. A pricing model can then be applied to obtain a value for the weather-based financial instrument using the historical weather information, the future weather information, and the risk-free rate.
The system for valuating a weather-based financial instrument of the present invention includes a weather history database that stores historical weather information for at least one geographic location and a weather forecast database that stores future weather information for the geographic location. The system may also include a financial database that stores information in order to calculate a risk-free rate. In order to access the databases and valuate financial instruments, a trading server is included within the system. The trading server provides the central processing of the system by applying a pricing model, and is responsive to a plurality of internal and external workstations that allow users, via a graphical user interface, to access the trading system.
One advantage of the present invention is that all futures, options, swaps, and other derivative financial instruments can more easily and confidently be priced when accounting for future weather.
Another advantage of the present invention is that information and data sets can be provided that enable traders to identify and capitalize on weather- driven market fluctuations.
Further features and advantages of the invention as well as the structure and operation of various embodiments of the present invention are described in detail below with reference to the accompanying drawings.